TheBull PREMIUM

Trends

&

Opportunities

The Frankenstein Economy

By Expert Panel |20.05.2013

Over the next few weeks, I will be publishing a series of columns that I hope will help investors understand what will be the global economic drivers for the next 10 years. I will discuss their effects on our lives and how to profit from the changes ahead through a series of 10 investment themes. So far we discussed the Growth of the world population and the situation of the Global Debt.

If you remember high school Economics 101 you will recall that there is a natural cycle to the economy. Periods of expansion are followed by periods of contraction. During the expansion new corporate leaders are born and during the contraction the weakest links disappear, paving the way for new innovations and future expansion.

In 1818, Mary Shelley wrote the novel Frankenstein. Everyone is familiar with the story; Dr. Frankenstein defies the law of nature and brings back to life a creature made from a dead corpse, which wanders from place to place in search of a purpose. In my opinion, from the great recession of 2008 has emerged Dr. Frankenstein, in the person of Dr. Bernanke. Like Victor, the good Doctor in the novel, Dr. Bernanke took it upon himself to resuscitate the economy with the unnatural injection of monetary easing. The effects were similar; the economy came back from the dead but without a soul. So weak that it limps along, barely escaping recession year after year.

I am of the view that the Federal Reserve and the US Government should have not intervened as aggressively in the natural cycle of the economy. Bankrupted financial institutions should have been nationalised, fixed and brought back to the market in a similar way as was done for General Motors. The weakest links would have perished, replaced by more dynamic and innovative corporations.

So what's ahead of us? Before we answer this question let's review how the Fed revived the economy over the past 5 years.

Fig 1

Looking at this chart (Fig 1), we can see that the Monetary Base has increased drastically since 2009, moving from USD800 Billion to USD2.9 Trillion, an increase of more then 350%. During the same period we also saw the Monetary supply (M2) increase by 55%. Any economic books written over the last 100 years would tell you that such an increase in liquidity should produce massive inflation. However, over the last four years, inflation was nowhere to be seen.

The lack of inflation since 2009 can be attributed to many factors, the most important being the banking systems hestitancy to lend to corporations and individuals, thereby restraining the velocity of capital. Coming out of the financial crisis of 2008, the banks looked to fix balance sheets and accumulate as much capital as possible. After four years, we'd expect banks to be aggressively lending, however they seem to show little confidence in the economic situation going forward.

The US unemployment situation hasn’t created an environment where lending could flourish. The following graph illustrates the poor employment situation America has faced since the financial crisis.

Fig 2

As the economy struggles to recreate the jobs lost during the great recession it is difficult for banks to lend confidently. However, the economy is producing jobs, slowly but surely, and the situation is gradually improving. Should we therefore expect more lending and inflation going forward?

The answer is in the hand of Dr. Bernanke. We see two possible scenarios from this point. Under scenario 1 the Fed reduces the accommodative stance taken five years ago. This would send interest rates higher rapidly and would probably trigger a new recession. This recession may annihilate all the benefits brought by the quantitative easing policy to date. Under this scenario stocks and bonds would plummet, cash would be king and the world would enter into a prolonged period of deflation.

However, as jobs are created and the economy slowly improves, the Federal Reserve may elect to keep interest low. This would probably lead to higher inflation. Under this scenario bonds would keep their value but present limited upside and stocks should extent their positive returns over the short to mid-term. In time, as inflation moved higher, we would expect the Fed to contemplate scenario 1 and again shock the economy and bring it back to square one.

The market is now addicted to accommodative policy and both scenarios present important down side risk going forward. I am of the view that the Fed will remain accommodative for many more years. We should, therefore, expect to see inflation slowly rising in the coming months. This slow rise in inflation will be beneficial to equity and hurt fixed income. This situation should remain until the Fed removes the punch bowl. We expect at least 18 months more of quantitative easing and, if the situation in Europe or Japan deteriorates, even longer.

This is not to say that stocks will go up in a straight line. The best method is to apply a tactical asset mix approach to your portfolio, overweighting or underweighting the different asset classes according to a three-month forecast. Personally I use a series of different indicators to forecast the direction of the market. The price of oil, P/E forward and FX directions are examples of quantitative indicators important to our approach. On the qualitative side, I like to see many bullish commentators on news networks before turning bearish and only when Roubinni and Faber become regular on the different shows do I start being bullish again…

In conclusion, the Federal Reserve needs to remember that playing God and trying to modify the laws of nature carries important risk. Like Dr. Frankenstein who perished at the hand of the creature he created, Dr. Bernanke will see his creation destroy his legacy. The question now is when?

(Disclosure: I receive no remuneration from any websites where I am published and do not publish or promote subscriptions to any newsletters.)

Eric St-Cyr is the founder and CEO of Clover Asset Management, a Brokerage and Wealth Management company located in the offshore jurisdiction of the Cayman Islands and servicing clients across the world. Before founding Clover Asset Management, Eric led the investment arm of one of the largest Life Insurance companies in the region, providing investors with impressive performance. Eric spent the first twenty years of his career working in Canada where he became Senior Vice President of one of the largest asset management firms, with assets under management exceeding $60 Billion. Eric can be reach at: eric@clover.ky

Click on the links below to read other articles from this week's newsletter